The Economics of Corporate Reorganization

7/29/2019 The Economics of Corporate Reorganization

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T H E E CO NO MI CS O F CO RP O RAT E RE O RG ANI Z AT I O NSUMMARY

I. The meaniiig of "faUure" and "iwngaiiiiatian," 2 9 . - 1 1 . The eco-nomica of reoqEaauatioo. Liquidation value of the aaaetB: speaialiiation, 82;epanlnlity, 83; costa of liquidation, 81. Value in reorganisation, 36.Unoertainty of computationa, 37. Readjuatment of c laims: the "abaolutepriority rale," 38. DfflScultiea: conflicting valuationa, 40; inducing newinveatment, 41. II I. Comparison of proceduraa. The major problema to besolved: deciding upon reoiganiiation or liquidation, 44; procuring new capital,46; dealing with diwenting minorities, 47; ensuring independent and dis-interested review, 48 ; keeping costs dom i, 40 .

It is a commonpUice that the reoiganuation of failed corpota-tiona is an economic process that is carried out in a legal forum.Legal writers on the subject are forever stressing the point thatecononoic considerations are fundam ental and well-nigh con trolling jat the same time, the economists' discussions of reorganisationhave a tendency to become so involved in the details of legal pro-cedure that the economic issues do not stand out clearly and dis-tinctly. Y et despite the agreement between lawyers and econo -mists that corporate reorganization raises problems that arebasically economic in character, it is not e a ^ to find in the litera-ture a systematic account of just what these problems are. Th epresent article represents a niodest attempt partially to fill thisgap. Although it was originally the intention to describe the veryimportant statutory changes in reorganisation procedure in recentyears Section 77B and C hapter X of the Revised Bank ruptcyA ct of 1938 limitations of space will no t permit this, and in th emain the treatment will restrict itself to those economic questionsth at will ha ve to be m et and solved regardless of the legal m achinerycurrently available. In other words, insofar as our analysis is valid

lall, it is almost eq ually applicable to the ou tmoded procedure ofreorganisation through receivership in equity, to Section 77B, andto Ch apter X . In order to simp lify the discussion the treatment islimited to private corporations whose activities are not deemed atlaw to be "affected with a public interest.''^

1. That is , we shall omit any discussion of the apedalissuea raised by tbefact tliat, at law, certain types of corporations aie deemed to provide services


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ECONOMICS OF CORPORATE REOROANIZATION 2 d

TEOS MBAinNO o r F A I L U B B A N D R E O B O A N IE A T IO NA nffTftiYiinfttinn of the theoretical literature in ecanomicsreveals that writers have apparently not thought it necessary todefine "failure" and rarely even em ploy th e term. O ne reads ofthe withdrawal of firms fnnn an industry, but usually there is noindication whether failure is taken to be synonymous with with-drawal or antecedent to it. F or the broader problems of economicadjustment the important thing is withdrawal of productivecapacity, and it is perhaps for that reason that the departure ofparticular firms which yet leave productive capacity behind hasbe en slighted . N ever theles s, for our purposes the conce pt of failurebecomes important.If a new enterprise is brought into existence, it is presum ptiveevidence that those supplying the caintal be&ve li iat the netreturns thereon in this opportunity are greater than those else-where available, due allowance being made, of course, for risk andunc ertainty elements.* O n the basis of these prospective returns,money capital is invested, real capital goods come into being, and

structure of the corjxwation is reared. If it be grantedthat new enterprises come into existence because of a prospectivereturn to invested caintal here greater than the then gcnng rate, itis perhaps less difiScult to indicate what we mean by failure in thenarrow economic sense: failure means simply that the returns tocaintal invested in the opportunity which the promotion wasdesigned to exploit have in fact so fallen short of those expectedthat, instead of the realised returns being greater than those else-where available, they have actually proven to be less. Otherwiseexpressed we mi{^t say that, costs being computed on an alterna-tive opportunity basis ai the time the enterprise began, costs are inexcess of returns.* In diagramm atical term s, average to tal cost is inexcess of average revenu e. T he enterprise is a failure in the sense

2. N o doubt many entennisea are annually promoted into existencewhere even the most cursory investigation would show the folly of expectingany positive return on the capital invested. A lmost ineredible ignontiM andoptimiam, idua a atrong uige to be one'a 0m boaa^ aa e.g., in the retaQtrade,seem to be mainly reqxn aible for sueh promotiona. T hese ventures, aa w dl aafraudulent prom otion achemes, will not eoneem ua here.8. T hia amounts almost to saying tha t the rate of return on peat historical


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3 0 QUARTERLY JOURNAL OF ECONOMICSthat, had this state of affairs been anticipated, the corporationwould not h ave been brought into being. Hen ce economically therehas been misdirected investment: the enterprise is a failure.

Failure in this sense, however, does not guarantee an im med i-ate withdrawal of productive capacity and economic resourcesfrom the industry . If the capital goods are highly specialized andquite durable, the unfortunate circumstance of returns less thanthose anticipated when the com mitment was made is not a reasonfor ceasing production. Th e returns from the sale of the ])roductmust, of course, be greater than the direct cost outlays incurred inits production, for otherwise the return on the specialized equip-m ent would be zero or negative. Y et in comparison with the goingrate of interest on historical investment actual return.^ may fallvery low before direct costs are n ot covered.* If is worth noting,how ever, tha t failure in this econom ic sense of an excess of averagetotal cost above average revenue need not be accompanied at once;by financial difficulties, such as a poor credit rating or inabilityto meet obligations to pay cash as they mature.'^ Finally, eventhough the firm should become financially insolvent, there is nocertainty that productive capacity will be withdrawn from theindustry.

While the foregoing distinctions and the conc.ept of failure inthe economic sense are important, it must be emphasized that inthe world of affairs the term "failure" applied to business enter-prises has a different and com paratively restricted meaning. W henin ordinary language w e say tha t a business enterprise has "failed,"we m ean usually tha t it has become invo lved in certain legal conse-quences because of its inability to meet maturing claims upon itto pa y mon ey. Business corporations operate within a legal sy s-tem which insists that obligations to pay money between personsm ust be respected. Th is is but on e aspect of the whole com plicated

4. For instance, moat street railway companies in the United States nowearn a negligible return on the purchase cost of the capital goods employed.Yet the roadbed, tracks, ca n, car-bams, wires, etc. being durable and highlyspecialized, such corporations continue to operate so long as they succeed insecuring an income from selling transportation service greater than the directout-of-pocket costs involved in producing that service by an amount at leastequal to an acceptable return on the net sonip value of the equipment. Whenthisreturnsfall bd ow that, th e tracks are to m up and the cars sold for kindling


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ECONOM ICS OP CORPORATE REORCtANlZATION 31inatitution of private property, and partly wh at w e m ean when w erefer to property as a "bundle of rights," the right to bring legalaction to secure paym ent of m oney due. In the business world,fulure ha8 the very definite meaning that some person or personshave instituted legal proceedings against the enterprise in order tosecure pa ym ent of their claim s. In a discussion of corporate reor-gan ization it seem s adv isable t o em ploy th is more cleaiHSUt conceptof business failure, rather than the economic concept, because itcorresponds more closely with popular understanding and legalusage. H ence where we use the term failure witho ut qualificationin the ensuing discussion w e shall mea n simp ly th at th e enterprise,here a corjmration, has come to a point where it is unable to meetthe cash claims upon it.Failure in the business sense just defined may lead either toliquidation or reorganisition of the corporation; and because itcannot meet its obligations as they mature, it has no choice in thematter and must accept whatever consequences the law provides.Creditors' claims are legally superior to owners' claims; thereforethe proprietors must allow creditors to pursue their legal remedies.Th e processes and the chan ges imp osed upon the failed corporationare not optional with the proprietors but obligatory.*By liquidation of a failed corporation we mean, as almosteveryon e do es, tha t th e particular working relationship in which th eassets now stand to one another is destroyed, and that they aresold off item b y item for cash.^ Th e sum s so yielded, after dedu ct-ing any costs incurred in the process, are then paid over to theclaim-holders in the order of their legally establi^ed priorities.

In reorganization, on the other hand, the juxtaposition of the6. From one point of view the above may not appear to be an entirelyealistic description of the courBe of even ts following business failure. Phiendlyreceiverships in equity, as well as 77B and Chandler Bill proceedings, have

long the legal process ntlwr tban to allow crediton ultimately to set it inotion. In actual practice, moreover, the shareholders of the debtor corpora-ion often have a say in the final plan of reorganisation, even in cases whereheir equ ity is quite small. But with the exception of one difficultyndicapped in ddng so. (See infra, p. 42.)


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3 2 QUARTERLY JOURNAL O F ECONOMICSassets is left substantially unaltered: the attendant adjustmenare no t so much th e withdrawal from the indu stry of cajntal goodas physical items representing productive capacity as they are aalteration of the amount and character of the claims against succapital goods as assets. T he value of the assets is recomputed (typcally revised downwards), at the same time that the face amounof the claims against the assets is altered by an equivalent am ounIn reorganixation, the readjustments occur in the rights and claimof different groups against the enterprise; only incidentally anpartially is there a breaking up and transfer of capital goods talternative uses. Such adju stmen ts are almost invariably accompanied by the investm ent of new capital which, of course, giv es risto new claims against the asse ts of the continuing enterprise. Thpresent writer would further restrict the term ieorgaxuKation tcases where the above changes are forced upon the proprietorbecause of actual or impending default on obligations to pa y cashand not initiated by the m voluntarily. B u t such a limitation of thconcept to what is sometimes called "involuntary" reorganiiatiom ay b e too great a break from traditional usag e.' Since the p resendiscussion will be restricted to involuntary reoiganiiations, however, we may use the word reorganiiation without a qualifier.

IITHX ECONOHICS OF RBOBOANIZATIOIT

When a corporation has failed, the important question whether it ought to be liquidated or reorganized, and if the latterwh at form the reorganization ough t to take. On wh at economiconsiderations does this decision tu m ? Surely it depends upon thvalue of the assets in their present com bination, a s contrasted w ittheir value in the dismembered state; in other words, upon th

8. Tbe writer would apply the term readjurtment to all cases invotvinthe restatement of proprietan* capital, the modifination af ahanholdani' cantiactual rii^ts, the abrogation of creditors' contract dausss by negotiatiowhich are initiated voluntarily by the proprietors, or tbeir ispnseatativvand are not the consequence of legal proceedings liav ii beea initisitad by n > nof aotual ot imminent dsfanlt on obligatiana to pay caab. In readjurtmsnt nlegal maebinety is placed in operation, because nothing baa oocumd vAmgives riae to an action at law or equity: the corporation baa violated no contraot, alfhoui^ the nature of tbe readjusbnait m i^ be tbe m odificrtiim o


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ECONOMICS O F CORPORATE REORGANIZATION 3 3

What the assets of a failed corporation will bring, if separatedi) on the degree to which the capital goods (machines, buildings,

ipm ent, e tc.) are specialized in character or are capab le of beingpted to alternative iises; (ii) on the degree to which their signifi-

(i) If th e assets consist largely of hea vy equipmen t item s, e.g.,

ted to other uses at all. M oreover the market for such second-uct differentiation is so large tha t eve n other enterprises in th e

a cond ition of oligopsony. If, on th e other hand, thessets are goods having relatively many uses, such as an ordinaryachinery (e.g. electric m otors), the y will ha ve a high sales value .

In the one case, the high degree of specificity of the capital goodsnd the prohibitive costs of physical transfer make their value inlternative uses alm ost zero; in th e other, their more general char-cter and sm aller physical bulk give th em a value apart from theirresent situation .

(ii) T he degree to w hich the assets are closely integrated w ithone another into a p at te m also tends to determine their liquidationa lue . Financial enterprises (bank s, insurance com pan ies, broker-ge and investm ent hou ses), as we ll as wh olesale and retail concerns,typically have assets whose value in separation is not greatly

(Merent from their value in the particular combination in whichthe y happen to stand at the tim e of failure. Obviously the sam ething would not be true of the high tension transmission lines of

9. An enterprise will usually pay cash claims upon it as long sa possible,


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3 4 QUARTERLY JOURNAL O F ECONOMICSan electric power company, the mains of a gas company, or thassembly line of an automobile manufacturer. In the latter casthe physical relation in which the capital goods stand to onanother is the m ajor reason for wh atever value t hey ha ve, and tharelationship cannot be undone withou t a hea vy cost outlay. M aters such as these tend to be all-important in determining what thassets of a failed corporation will bring if disassembled and so ld ipiecem eal fashion.*

Not all the ajssets of a failed corporation, of course, will be othe capital goods type: there are the working capital assets alsoIn the main these are separable, much as the assets of financiaenterprises, w ithou t great loss of va lue . Re ceivables, inve ntorieand the like are usually less difficult to evaluate, and in any givecase one can com pute their liquidation va lue within oarrow limits.

(iii) Our interest in the v alue of the a ssets of a failed corporation in liquidation centers upon their value net of any liquidatiocosts. The costs of liquidation will include the labor and capitacosts of disassembly, plus any legal costs (e.g., a referee in bankruptcy) th at are inevitable in the process. Such costs are nohowever, a fixed sum, but will vary with the methods employedA very rapid liquidation may mean that less is received for th

1. The two characteristics of specialised uses and separability are, ocoune, not entirely unrelated: capital equipment that is highly spedtl&tBioften closely integrated with otJier capital goods from which it cannot bseparated easily or cheaply. In some measure, also, it would appear tbat theris an inverse relationship between the degree to which capital goods have a lternative uses and aie separable witbout substantial loss in value, and tbe degreto wbich tbe enterprise is engaged in productive operations where the economies of large-scale production bulk laige, especially if tbe latter are mainlphysical in character. I do not believe tbe relationship holds all the wathrough, however, in tbe sense that where we find the one we invariably fintbe other.2. Complications may arise where the assets include securities sufficiento control subsidiary copupanies. Here tbe value of tbe stock interest will bdetermined by the relationship between the parent and the subsidiaiy and bdie possibility of selling the contndling interest to another corporation. If thsubsidiaiy is but an integral part in the productive oiganisation of the failecorporation, e.g., manufactures parts for, or is merely tbe marketing agency oits parent, then the worth of a controlliqg stock interest therein is mainlydependent upon the fate of the parent corjioration. On tbe other band,

public utility holding company, controlling operating companies in differensections of tbe country, does not add very much to thmr value over and


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ECONOMICS OF CORPORATE REORGANIZATION 3 5

a ve the greatest w orth. M oreover, a hurried dismemberment b yrutal metho ds, e.g., dy nam ite and crowbars, m ay b e cheap if on lyhe co sts of dismem berment are considered, bu t m ay b e very costlyon a net basis if whatever alternative use value the capital equip-ent possesses is destroyed thereby. In general we assume th athose methods of liquidation are employed which will yield theiftTiTniifn va l u e s u m .

Le t us designate this ma ximum value obtainable from liquida-on b y the symbol L. For any enterprise which has failed, L canust b e comp uted before the relative wisdom of liquidation oreorganization can be determined.* Fo r as w e ha ve already argued,y B) is greater than L, the corporation ought to be reorganized;f n ot, it ou ght to be liquidated so far as purely econom ic considera-

In determining th e value in reorganization of the a ssets of th eas Oiey

ow dand. It is this am ount, which we ma y call R, which must beL.A failed enterprise will almost invariably require additional

investm ent as a part of the reoi^anization plan . From on e

ses as to a ny other probtem of cap ital inv estm ent; the appropri-en ts of capital and increments of retum. If w e will, an extension

al is equal to the rate of interest. Th ere is a3. When we say that the liquidation value of the enterprise can be com-

L can be computed with reasonable accuracy; probably in

4. Often to replenisb working cajutal reaources wlucb bave been dissi-in to val inunediatdy preceding failure is quite enough. In other


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3 6 QUARTERLY JOURNAL OF ECONOMICScertain optimum amount which under the given circumstances iwill pa y to invest in reorganizing the enterprise. Call this a m ou nof new money investment M, whose determinants are the rate ointerest and the marginal efficiency of capital investment in thenterprise to be reoi'ganized.Let us now assume that, if the optimum amount of capital invested, the reorganized enterprise as a whole will have, on thbasis of its prospective earning power, a value V. That is to saythe value of th e assets of th e failed concern as the y now stand , pluthe additional investm ent which it is worth while undertaking, wigive the reorganized enterprise a U/tail value designated by V. Bif this be true, it is obv ious at once th at in reorganization the v aluof the assets of the failed concern ax they now stand is indicated bthe expression (VM). This residual we may designate by Rthat is, (FAf) equals 22.' Now if we know that the value ireorganization of the assets of the failed concern is R, and thatheir value in liquidation is L, it follows at once that if A is greatethan L, reorganization is th e b etter a lternative ; while if L is grieatethan R, liquidation is the proper choice.

We have endeavored to show that the value of 22 is a derivtive of V, the value of the enterprise as a whole if the optimumam ount of new investm ent is com m itted to it. W hat opp ortunitieexist for the profitable investment of capital in the reorganiiatioprocess will of course depend up on th e whole factual atu at ion surrounding each instance of failure. In some cases further investm enwill be a waste of resources, because th e earning pow er of the reoiganized corporation will still be very low. If tha t be true, dissolution in the most economical manner will best serve all interesteparties. In other cases, however, the marginal efficiency of cap itainvestment will be distinctly above the going rate of interest anthe enterprise can be reorganized with considerable profit. In thlast analysis, reorganization is called for only on the belief thatis greater tha n L.*

6. As in the case of L, S must be interpreted as net after tbe dedufltiaof any reorganisation expenses.6. Throughout the whole of the present section we have talked about thvalue of the assets as a whole in reorganisation as opposed te liquidationStrictiy speaking, this is an oversimplification. Assuming that l i is greate


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ECONOMICS OF CORPORATE RMiRGANIZATION 3 7It may not be out of place, perhaps, to emphafdce that in

determining both F, the value of Uie reoiganized enterprise afternew capital has been invested, and R, its derivative, the value inreorganization of the assets of the failed corporation eu they rumstand, the computations must be made on anticipated returns oncapital inve stm ent, rather than upon definite c ertainties.' A s in allcases of captal investment in the real world, the prospective yieldis inherently tinged with uncertainty. M oreover, since R must bebased upon estimates, it is impossible to demonstrate the correct-ness of an y an gle co m pu tation: equally com petent persons arelikely to hold different view s as to just how laige R is. And inthe reorganization process there may be considerable bickeringbetween groups of claim-holders over this question, e.g., share-holders insisting they have an equity that bondholders refuse torecognize.

Our discussion so far has centered upon the relative values afthe assets of a failed corporation in reoiganization and liquidation.There is also, however, the question of readjusting claims againstthese assets.

Failure in the business sense is itself evidence that the totalface value of the shareholders' and creditors' claims against theassets is greater than the value of the assets as they now stand;no t all claims can be paid in full. Le t us suppose tha t R is greaterthan L, and that therefore reorganization will proceed, but thatnone the less the value sum 22 is less than th e tota l face amo unt ofthe claims against the assets.* Let us designate the total facetext would have been greatly extended if the diaouBBion had been earnedthrough in this more accurate manner. Any reader can supply the ne cc na iyamendmentB or qualificationa that the more pradae formication impoaea. Uwe w ish, we m i^ deaigDate by the qymbola n, rt , -Fn the worth dt the indi-vidual aaaetitema in reoiganiiation, and by l , , l i , In their worth in liquida-tion. On thia baaia we have L-U+l+U+. +U and R~ri+rt+.. -m .7 I t m i ^ t be urged that in practice new capital inveatment to carrythrough a reotgan iiation haa to g ive promiae of greater ret un a than thoae t obe had in alternative oppartunitiea, if funda are to be aecured. When an enter-pHae faila, an aura of g loom may ao apread about the proceedings th at peraonatake an unwanantedly peaaimiatic view of the probable retunia on additionalinveatment. Th e vulgBr phraae "throwing good mony after b ad" epitomiaeathe mental reaction of m any penona towaida new inveatment in a foiled coi^paration. Feeaimiam ia often aa typica l of reoigan iiation aa optimiam ia ofpromotion.


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38 QUARTERLY JOURNAL OFECONOMICSamount of the claims by the symbol E. These will consist of credi-tors' claims, C, and owners' claims, 0, so that E=C plus 0.* Nowif i2 is less than E, it is quite clear that some means must be invokedby wliich the two can be equated, for in the last analysis the totalamount available for partition among the claimants is no greaterthan R, as the assets now stand. The problem is, by what proced-ure should the various individual items constituting E be reducedso that their total is jtist equal to RV

If all claims against the assets were on an equal footing, thenE R

each claim would merely be reduced by the proportion . YetE

by law and agreement the C claims rank ahead of the 0 claims.The appropriate logic, therefore, in reducing EioR would seem tobe to conmience with the 0 claims and, in reverse order of theirrelative priorities, to lop off claims until E was reduced to R. Ifafter all the 0 claims were wiped out E were still greater than R,then it would be necessaiy to follow the same procedure with the Cdiscoimtod earning power. It is of slight interest to a bondholder, conoemed\rith principal and interest sum s, to know that on an original eost less depreci-ation basis the assets exceed the debts, if these assets will not earn enough topay his contractual interest. If historical outlay cost were relevant, the financial problems of the railroads of the United States would have long sincedisappeared rather than become more acute.9. All claims will be either owners' claims or creditors' claims, althoughin any actual case there are likely to be several different types of owners' andcreditors' claims.1. A considerable literature has grown up about this question of alterna-tive principles for reducing EiaR. Much of it is controversial, and not alwayshave the disputants focuraed their argumentation on precisely the same issues.The following works are especially worth studying, however, and the ensuingdiscussion in the text has benefited greatly from the ideas therein contained.J. C. Bonbright and M. M. Bergermann, "Two Rival Theories of PrioritySights," Columbia Law Review, Vol. 28, pp. 127-166; unsigned note, "The'Fair' Flan under Section 77B," ibid.. Vol. 36, pp. 391-404, 649^666; JeromeFrank, "Some Realistic Reflections on Some Aspects of Coipomte Reoiganiza-tion," Virginia Law Review, Vol. 19, pp. 641Hi70, 69S-718; E. B. Barrett,"Fair Han" under Section 77B, applicability of the B oyd Case, Michigan LawReview, Vol. 34, pp. 992-1,002; R. S. Foster, "Conflicting Ideals for Reotgani-zation," Yale Law Journal, Vol. 44, pp. 923-960 . There is a good and easilyaccessible discussion of the "fairness" problem in corporate reorganization inJ. C. Bonbright, Valuation of Property, New York, 1937, Vol. II, pp . 864-70 .The earlier cases and approaches to the problem aie discussed in J. K. Rosen-berg, R. T. Swaine and R. Walker, Corporate Reoiganintion and the Federal


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ECONOMICS OFCORPORATE REORGANIZATION 39claims until ultimately the diminished E was equal to R} Thescheme just outlined for scaling down claims, made necessarybecause E is greater than R, has come to be known as the rule ofabsolute priority.* It seems to accord ^ t h the legal principlesusually followed for partitioning property between superior andinferior claimants. Contracting parties are presumed to knowwhat they are doing, hence when shareholders admit creditors(e.g. bondholders) as prior claimants to assets and earnings, thepresumption is that they know what this means.* Therefore, iS thecorporation fails, it is only reasonable to Insist that the absolutepriority rule should be the general principle adhered to in paringclaims against assets and earnings. In solvent enterprises this iscertainly the rule followed: operating losses are charged against the2. Since the total face amount of the claims in particular orders ofpriorities is , in practice, often quite large e.g., there m ay be an issue of pre-ferred shares amounting to several m illions of dollars it may be necessary toapply a less than 100 per cent reduction within a particular group in order toequate to A; all claimants in any one group staJid onan equal footing andmust be treated alike. Bu t, as between groups, surely the logical principle inscaling down claims is to wipe them outcompletely, in invetse order of theirpriority, until those left are no greater than R.3 . Bonbright and Bergermann, who seem to have christened th is doctrinethe "absolute priority rule," were at the time of writing willing to allow amexception in the case offirst ien bonds carrying such a low rate of interest thatbefore failure they typically sold below pw . Th ey aigued (op. dt . , pp. 166-167)that to g ive these bondholders par for their claims would {noduce the somewhatparadoxical result that th ey were better off after the reorganisation th an if nofailure had occurred; for in reorganisation they would get par for their claims,while without failure their bonds consistently sold below par because of thelow contractual rate of interest.To th e present writer, however, this seems an illogical mode of reasoningrunning contrary to the whiole spirit of the absolute doctrine. Eiven though thebonds have a low face rate of interest, they would gradually appreciate to paras their m aturity date approached, if the enterpriseremaineda going concern.But according to the contract, default on the interest automatically advancesthe maturity date of the prindpsl, precisely as if the ultimate maturity hadbeen reached. Hence there is no reason why first lien bondho lden should havethdr claims scaled down simply because the corporation had itself broughtabout the m aturity date defatio somewhat earlier than antidp ated originally.Ultimately the bondholders would get par if the enterprise stayed out of thecourts. They should get the same, if they are first claimants, when it fails.

4. We do n ot m ean to imp ly that in certain contractual relations specialsafegiu ids will not be necessary to minimise the dangers of sharp dealing: thecomplications of modem bond indentures are probaUy a case in point. Thereis no reason to suppose, however, that shareholders as a class are more apt to


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4 0 QUARTERLY JOURNAL OF ECONOMICSowners' claims, not the creditors', and eveiyone accepts the prac-tice as a m atter of course; symm etrically, therefore, one has a rig|itto expect the same policy when concerns fail.*

Although the principle of absolute priority in scaling downclaims is theoretically precise and, in the writer's opinion, emi-ne ntly reasonable, we mu st not overlook certain difficultiesthat m ayarise in its application.* Th e first of these is tha t V, from which R

6. Observe the following by a legal writer. "Reoiganisati(xi has sup-idanted liquidation as the normal consequence of the failure of laige corpora-tions. It is offered aa an alternative to the sacrifice of going concem valueswhich usually exceed liquidation values. Yet creditors' and even prefeiredstookholden' rights are normally concdved of as ri^ts and priorities inliquidation. Th is is both th e abstract legal conception, and the nature! impU-cation of the financial documents and sates literature, whether used to obtainmercantite credit or f sell securities with liens and preferential rights. Thee^n ctation s of priority are created both with reference to what may berealised in the event of corporate failure and as sanctions to minimise the risksoffaihire. The promoters amd manageis identified with the junior stodc are tobe kept from rash solidtation or use of capital by the f e u tha t whatever lossesoccur must wipe out th dr ow n investment stake. In supplanting liquidationas tlie corporate day cf judgment,reorganisationmust offer equivatent oppor-tun ity for realisation of tbese rights and esqiectations cf priority yet theattempt to insist on strict enforcement of priorities usually interferes with theconservation of gd ng concern values. The incom patibility of these two desir-able objectives gives rise to confiicting ethical attitudes and ideals onepunitive and tlie other practical. These ideals manifest respectively the basichuman passions of vengeance and avarice. Each ideal has had its own typicalchamjuons." R. S . Foster, "Confiicting Ideals for Beaiganisation," Yale LawJournal, Vol. 44, pp. 826-026.

6. Among le(^ scholars the absolute priority rute is, I think, generallyaccepted as "fair and reasonable." Th e one notable exception seem s to beMr. R . T . Bwaine, who has propounded an altem ative prindple known as the"relative priority of income rule." By contrast with the absolute rule, therelative rule would insist th at fainiess is achieved in reoiganisation {dans pro-vided the parties in interest are left undisturbed in the order of their primityof da im s on income. Th at is, those having a first claim on income before fail-ure will be given a fint daim on income in the reorganised enteiinise, and soon down the lioe. Strictly applied this would meam tiiat no group of da imantswould ever be wiped out entirdy in a plan of reorganisation, although whatsome would recdve would have littte or no value a t all, because the wtrmngi ofthe reaiganised corporation would never amount to enough to y ield them any-thing. The relative rute would countenance the conversion of first amd uncon-ditional daims, e.g., fint mortgage bonds, into first contingent claims, e.g.,income bonds, even though common liarilinWimi were given, say, option war-rants under the same phm. For a statement of the rda tive doctrine see Mr.Swaine's articles "Re(gaDisation of Corporations: Certain Devdopments ofthe Last Decade," Cdumbia Law Review, Vol. 27, pp. 901-081; and "Rear-


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ECONOMICS OF CORPORATE REORGANIZATION 4 1i8 derived, is necessarily based upon expectations as to the earningpower of the reoiganized enterprise; consequently, within a cer-tain range, different claim-holding groups may hold conflictingviews as to the value of B, and in the nature of the case it is impos-sible to demonstrate the absolute "correctness" of any one valuefor R. An extremely "conservative" view of the earnings of thereorganised enterprise will mean the exclusion of certain claim-ants in reorganization who would be admitted if V (and hence B )were appraised more optimistically. In drafting the reorganisa-tion plan it may therefore be proper to grant them contingentclaims and await developments rather than to blot them outentirely. Should the pessimistic forecasts prove correct, their con-tingent claims will then beworthless, but not if thereverse s true.'A second difficulty in rigidly applying the absolute priorityrule in practice is associated with the acquisition of indispensablenew investment. It is the input of additional funds, M , thatrenders V greater than B ; moreover, if no funds can be raised fromany source, the amount available for partition among the claim-ants against the failed corporation is L, which is by assumptionless than B . Now because of the hesitancy which people m ay feelabout investing in an enterprise that has once failed, the contribu-tors of new money may drive a hard bargain and insist that theybe given claims against thereorganizedcorporation greater thanthe amoimt of the new capital they invest, i.e., M. In value termsaerve ntfa sr than d im inate Btratified capital BtniotiueB, it i s premiaed fhnnigh-out on the asBiimption that i t ia socially wiae to accord debton CBbaraholden)lenient troatment at the eipenae of ctedito n. Yet the justification for such anassumption is by no means sdf-evident. It could scarcely be aigued that, as adaas, bandholden are better able to bear losses than shaiehoIderB; indeed, agood case might be made for the revene. Those who uige the virtues of therelative rule often emphaaiie the coscntial similarity of bondholders and shar^holdan as joint adventurers taking risks; yet these same persons would cer-tainly be unwilling to grant bondholders more than their contractual rights,had the corporation proven wonderfully successful instead of a dismal failure.7. As is com mon knowledge, shareholders in real cases of reorganiiationare apt to insist th at the assets of the failed corporation are worth more thancreditors will adm it, and tha t under any "reasonable" valuation the y have anequity which should be recognised. Under equ ity receivership reorganiaationsthere w as no satisfactory means of resolving such d isputes, but under 77B andCShapter X of the Chandler Bill the court has power to decide. Th e basicsource of such disputes, however, is that R is based upon expectations. Itseems t o the present writer that whatever virtues Mr. Swaine's rdative priority


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4 2 QUARTERLY JOURNAL OF ECONOMICSthe total claims against the reorganized corporation available forallocation are, of course, exa ctly equa l to V, the value of the enter-prise after the new capital has been inve sted to reorganize it. N owif investors did rud demand concessions on the ground that theywere putting funds into a corporation that has already failed once,they would be satisfied with claims against the reorganized enter-prise of an amount M, which would leave for the old claim-holdersan amount B.' But if those who provide the new capital to carrythrough the reorganization insist on favors, they will demand newsecurities with a value greater than M. This means that the oldclaim-holders will obtain from the reorganization something lessthan B. Theoretically, if those who supply the new money actedin concert they could force the old claim-holders to accept claimsagainst the reorganized corporation of an amount less than B hyas much as BL, i .e., give them no more than L. For w ithoutnew capital the altemative to reorganization is liquidation, andtherefore those holding claims against the failed corporation willgain through reorganization provided the y get a nyth ing more th anthey would receive in liquidation, i.e., if they receive claim s againstthe reorganized corporation having a value greater than L. Sincethere are altemative means of raising cash, that is, no monopolyexists among holders of cash balances, the old claim-holders prob-ably will no t have to concede as much asBL; but they m ay wellhave to sacrifice something in order to get new cap ital. If sacrificesdo have to be made in order to call forth new investment, theyshould be exacted from those in the lower orders of claimants.As we have a lready observed, the old claims, C and 0 , are arrangedin a hierarchy. H ence if th ey are to receive less than B in reorgani-zation (because of the indstence of those advancing the newmoney), the sacrifices should be imposed on the principle ofabsolute priority.

In each case of reorganization, of course, the sources fromwhich the new money is to be raised will tend to determine thekind of sacrifices imposed on the old claimants in favor of thesuppliers of new funds. If those who invest new mon ey have hadno previous connection with the venture, they may insist that thesecurities they receive shall occupy an exclusive^ first claim on


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ECONOMICS OF CORPORATE BEOBOANIZATION 4 3holders to provide the necessary cash may well take the form ofoffering them more for their old claims than they ought to receiveunder a strict application of the rule of absolute priority, i.e. morethan their proper share of Ji. For example, to obtain new capitala group of shareholders may be given new shares having a valuesubstantially greater than the sum of the new cash they contributeand the value of their interest in B.' In many a case of reorganiza-tion in the real world, of course, cash will be derived from boththese sources, and as a consequence both tyjies of sacrifice will bemade by the existing claim-holders.

These genuine and by no means negligible difficulties oftenencountered in applying the absolute priority rule to actual casesof reorganization m ust not suggest that we regard t as impracticalor unworkable. On the contrary, since claims have to be scaleddown in reorganization, it is essential that the ideal which theprindple formulates be ^ven explicit statement and accordedgeneral acceptance by the courts. We can work out the niceties ofparticular reorganization plans effectively only if, conceptually, wehave an ideal towards which we are striving. Since under the newerreorganization statutes judges and others are forced to pass uponthe "fairness" of reorganization plans, it is extremely importantthat they have common concepts of faimess which are clear andprecise as ideals. Otherwise only chaos will result. The absolutepriority doctrine seems to provide both a simple and reasonableideal which can be set agunst actual plans of reorganization forcomparison and judgment. If because of practical considerations

0. The po int m ay be made clearer and more precise as follows: grantedE^C+0, let C-(ei+Ci-|-eO and O~(R.Let us assume that in the instant case E>R by the amount (oi+Oi); in otherwords, if we like, that the second preferred and common shareholders have noequity in the assets. Then it follows that R (c i+c i+ C i+ O i), or more brieflyi2~(C +oi),andc ^cou rBe iZ C-o i. Now if the creditorsfind t unnecessary tomake a ny concessions in order to get thefirstpreferred shareholders to advanceall the new m oney, JIf, th e fint preferred sharduddars will receive daim s againstthe reorganised corporation of a value (M+oi). But in the case under discus-sion we assume th at first preferred shareholders need persuading in the form ofmore attractive terms; hence they are offered claims against the reorganisedcorporation of an amount greater than JV+ oi. B ut if the prafem d shareholdersget more, the craditors must g et less; therefore th e creditors will obtain d aim s


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4 4 QUARTERLY JOURNAL OFECONOMICS such as the inherent d ifficulty of determining V and its deriva-tives precisely and the direct money cost of attempting to do so'the absolute principle is only approximated, not fully achieved, inreal world cases of reorganization, we must accept such compro-mises as reasonable and defensible, b ecause of the inherent compli-cations of the whole problem of corporate reorganization.

I l lCoifPABIBON OF F B O C I I D U B B B

Since corporate reorganization involves a readjustment ofproperty rights, the legal system must provide a forum in whichthese adjustments can be carried out. In the United States thisforum was for a long period that of the equity courts, but since1934 the bankrup tcy courts, first under Section 77 B and now underChapter X of the Revised B ankruptcy Act of 1938,* have largelydisplaced those of equity: traditional and customary procedurehas yielded to codification by statu te. Space does not permit ac(nnprehensive and comparative discussion here of the three sys-tems of reorganization, and besides, with the exception of ChapterX , w hich has only recently come into effect, such a discussion wouldbe threshing old straw.' Instead, we shall submit certain criteria

1. It may be observed in passing tha t, where 7 is so miuh a matter ofesqiectation and judgment, increased cost outlays to determine its amounty id d very little increase in th e precision of the estimates after a certain ratherearly point.2. B y reorganisation in equily w e mean, of course, that ifyBtem wherebycourts of equity, by the appointment of a receiver, were able to m aintain intactthe asset fimd ida failed corporation against the on daui^ t of creditors, pend-ing theprepuation of a plan of reorganisation by whidi theassets could besold at a receiver's sale as a umt and free from the daims of creditors.Reorganisation under 77B means reorganisation under the CorporateReoigaoisation Act (Section 77A and 77B of the Bankruptcy Act) enactedJune 7,1 08 4 (48 S ta t O il), amended August 20, 1088, 11 U.S.C.A. sections206,207.B y rem ganisation under the C handler B ill we m ean corporate reorganiia-tion under diap ter X of the revision cf the B ankruptcy Act of 1808 and actsamendatory and siqiiilBmentary thereto, approved June 22,1988, Public No.006, 7IStih Congress, O L 87S, 8d Sen ion.8. The following refisrenceB w ill be useful to anyone who is not familiarwith tha three q it sm a of mn ganiaation. Rosenberg, James N. et al., Corpor-ate RaovHiiaatiim and tha F sd sn l C ourt, New Yoric, ISM , deals with equity


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E C O N O M I C S O F C O R P O R A T E R E O R G A N I Z A T I O N 4 5by which, it i s believed, one may compare therelativeeffectivenessof these systems or any others that may later be enacted.When we pass from theoretical constructions to corporatereorganisation in the worjcaday world, certain practical problemsarise to which any legally established reorganization machinerymust yield a solution: the acceptability of the solutions reachedand the manner of reaching them provide the criteria by whichone ^ t e m ofreorganizationcan be compared with another. Inother words, if we wish to compare the relative m erits of corporatereorganization through receivership in equity, under 77B, o r underChapter X, we may conveniently do so by asking just how andwith what success did each yield a solution to certain practicalproblems. What are these problems? We suggest that the follow-ing five are of primary importance, and that the way these prob-lems are handled in practice condemns or commends the reorgan-ization system being scrutinized.

First is the crucial problem of deciding whether reorganizationor liquidation should follow upon business failure. Since theclaimants on the assets of the failed enterprise, the contributors o fnew capital, and the general public will be harmed, if an enterpriseis reorganized that ought to be liquidated, this problem is of pant-mount significance. Consequently one needs to examine thereorganization machinery from this point of view. To what extentand by what methods does the machinery bring this question intothe open and facilitate the formulation of a prompt and satisfac-tory answer? Does the machinery, for instance, make it easy forcertain groups to insist uponreorganizationeven though the valueof the assets of the failed enterprise to the claimants would begreater in liquidation? The choice between liquidation and reor-ganization has a significance extending beyond the purely privateinterests of the claim-holders against the failed corporation andthose who invest new capital. If capital resources and other agentsof production are retained in (or drected to) one use when theirproductivity in another would be greater, there is a genuine, ifstatistically unmeasurable, reduction in the conmiunity's realincome. Moreover, unwarranted reorganizations delay the adjust-X : Corporate Reorganisation under the Federal Sta tute , Chicago, 1038. Th ewriter expects to publidi a comparative treatment of tiie tbme syBtems of


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46 QUARTERLY JOURNAL OF ECONOMICSm ent of excessive productive cap acity to a shrunken dem and, andtend thereby to produce depressed conditions throughout a wholeindustry. Indeed, one might a i ^ e w ith some force that petitionersfor legal assistance to carry through a reorganization ought to berequired to submit convincing evidence that reorganization andno t liquidation is the appropriate remedy in the instan t case. Inother words, on broad economic considerations perhaps the pre-sumption ought to be that the enterprise should be liquidated,thereby placing the burden of proof to the contrary squarely onthe petitioner. T his does not m ean, of course, that v ery few entei--prises which failed would actually be reorganized; only that itought not to be taken for granted without dem onstration thatreorganization will follow failure as day follows night.^Second is the important question of the extent to which theparticular reorganization machinery tends to make it easy orcomparatively difficult to procure the necessary new capital tocarry through the reorganization, assuming it to be warranted.Unnecessary obstacles here are a serious indictment, since, as weha ve seen, new inves tm ent is usually indispensable in the rehabilita-tion of a failed con cem . M ere sta tu tes or legal mach inery cannotassure, of course, that the necessary funds will be forthcoming;but by making it possible to give the new capital contributors anexclusively first claim on assets and earnings through the displace-

4. Section 77B and Chapter X represent some advance over equity pro-cedure in handling this proUem . Under e quity the question of liquidationversus reorganisation w as fomudly posed in the pe tition for the appointm entof a receiver. If the receivership petition were denied, reoiganization becamealmost impossible, because there was no very satisfactory way of preventingdaim-holders from dismem bering the assets. Co urts seem to have been proneto appoint receivers rather freely for failed corporations, without much con-sidering wh ether liquidation or reoiganisation diould occur. Fo r evidence onthis point see U . S. Senate R epo rt N o. 366, 73d Congress, 2d Session, W ash-ington, 1S34. In a ny case, the problem was not a s squarely posed in tbe pro-ceedings as it should have been.

Under 77B the tendency was to be lenient with debtors and their petitionsfor reorganisa tion. One aut hor ity, however, contends th a t th e whole implica-tion of the "feasibility" and the "good faith" requirements re a proposed planof reorganisation were th a t th e enterprise should only be reorganized if it w ereclear th a t reorganization was bett er tha n liquidation. See Finle tter, op. cit.,pp. 63-66.Chapter X, by allowing more parties to be heard and by requiring the


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ECONOMICS OF CORPORATE REORGANIZATION 4 7ment of previous liens and claims, new investment may be greatlyencouraged." Similarly, if the direct ou tlay co sts of the reorganiza-tion p rocess are kep t to a minim um consistent w ith other desirableobjectives, an d if it is unnecessary t o p ay certain claima nts in cash,new cash will be more readily forthcoming, because less will beneeded and more of it will go for productive purposes, rather thanto foo t th e bill for previous errors. In variou s w ay s the reorganiza-tion machinery may so function that prospective investors areencouraged, not warned off, and have emphasized to them thefavorable returns available on new investment.

Third is the problem of dissenting minorities in corporatereorganization. T his ve ry practical problem arises ou t of the con -fiict of tw o generally accep ted and comm endab le principles. Firs t,that except on a special showing, persons should be allowed tom ake such use and disposition of their ow n property as their ownwisdom (or lack of it ) seem s to dictate . Second, tha t where diffeivences of o^nnion arise in matters of policy, the accepted mode ofreaching an agreement is b y the principle of m ajority rule. In th em ain, the law ha s been careful to block the m an y attem pted inroadsupon the rights of individuals to deal with their own property.On the o ther hand , it is doubtless true tha t, under certain circum-stances, strictly to uphold the legal rights of one individual or asmall group will damage others composing a much larger group.The problem of resolving differences of opinion, where individualjudg m ents are alm ost certain to differ, well emp hasizes the un avo id-able conffict occasioned by the juxtaposition in reorganization ofth e competing ends of "justice" and " expediency." Som e m eans ofreaching a workable decision and of forcing that decision upon thedissenters there must be, unless one is willing to accept the pros-pect of well-nigh unending debate; yet one cannot deny that a

6. The main weakness of equity reorganization in this respect was thatdissentere to the proposed plan of reorganisation had to be paid in cash inorder to free the assets for reorganisation. Yet how m uch cash would benecessary for this purpose could not be determined until it was known howmany would refuse to come in under the plan. On the other hand, no ve rydefinite plan could be proposed and gain general acceptance, so long as theamount of cad i to be raised was indeterminate. To gain approval of a plan theamount of cash to be raised had to be known; but the amount of cash to beraised to carry the plan through was an unknown, so long aa the percentageof agreement thereto w as uncertain.


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48 QUARTERLY JOURNAL OF ECONOMICSsimple and unrestrained form of majority rule in corporateganization can easily become a vehicle that crushes justice (in anacceptable sense) aside instead of carrying it along. Such a resulis indeed facilitated where, as is so often the case, a sizeable proportion of the parties in interest have little or no opinion one waor another, e.g. the small shareholder in a large corporation. Certainly no "ideal" solution to the problem of dissenting minoritiein coriwrate reorganization can be formulated offhand; but thway the problem is handled provides a useful point of comparisobetween reorganization procedures.'

Fourth there is the problem of obtaining some independenand disinterested review of the plan of reorganization, as finallevolved, in order that its faimess, its feasibility, and its generaappropriateness in view of all the known facts may be appraisedSome persons would perhaps deny that the legally establishemachinery ought to make any provision for such a review. Thargum ents supporting this position are almo st exclusively foundeon the assumption that only the rights of private property holderare invo lved in corporate reorganization, and th at therefore thparties in interest and in confiict should be allowed to work outheir own solution witho ut interference. As already argued, however, public as well as private interests are at stak e; hence an in dependent review is no t on ly proper bu t, at least in large, quasi-publicorporations, necessary. E ve n if we grant tha t on ly priva te interests are at sta ke , a good case could be made for an impartial reviewon the ground that a reorganization plan evolved out of confiict apt to consist of a bundle of compromises neither satisfactory tanyone as a whole plan nor carrying much assurance of successConsequently there should be the opportunity, at least, for somcompetent but disinterested party to examine the plan and to suggest changes therein.'

6. Some persons have fd t that 77B went too far in allowing two-thirdof the creditors and a majority of the shareholdwis (where they had an equityto bind the others. Bu t the pereentagss are retained in Chapter X .7. Under equity reorganisations the courts had an indirect power ovethe ultimate adoption of a plan of reorganisation through thair power to fthe upset price and to confirm or reject the sale of the assets as a unit. Unde77B th e bankruptcy court had to pass upon the faimess of th e plan, althougnot until it had been accepted by th e parties in interest. Chaptw X allowa th


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ECONOMICS OF CORPORATE REORGANIZATION 49There is another side to this question of independent review

which does not pertain to the actual plan of reorganization som uch as to the whole proceedings. A t least in democratic coun -tries, national governments ostensibly strive to promote generalwelfare through the exercise of legislative, judicial, and executivefunctions. Con sequently the y hav e a general obligation to preven tthe established procedures for the reorganization of corporationsfrom being used by special groups for their own profit and aggran-dizemen t. In other words, the reorganization forum is presumablydesigned to provide a prompt, inexpensive, and equitable methodof dealing w ith failed corporations. I t would be a strange andintolerable end result if it actually so functioned that investmentbankers, let us say, or corporation lawyers and executives wereable to sequester for them selves a l a i ^ fraction of the availableassets at the expense of creditors and shareholders. Since suchdangers have not in the past been entirely illusory, there is needfor an independent supervision of the proceedings as a safeguardagainst the reorganization machinery being bent towards the pur-suit of private ends not in accord with its purposes.'

Fin ally, there is the very obvious problem of keeinng dow n t hedirect and indirect costs of corporate reorganization to a m inimumfigure consistent with other desirable objectives. Obviously thereis a confiict of ends here, since a minimum cost of reorganizationm ay be incompatible w ith, say, the objective of maximum faimessor other desirable attributes in reorganization.* Nevertheless, cer-tain costs of reorganization may be kept down without sacrificingother dedrable objectives, and so far as possible the legally estab-lished reorganization m achinery should m inimize the se. Fo rwhatever costs of reorganization there are must be paid eitherfrom the assets of the failed corporation or from the new capitalcontributed for its reorganization. Either wa y the am oun t whichclaim -holders in the aggregate can receive is reduced. T he directcosts of reorganization have usually consisted primarily of legal,

8. One of the m ain purposes of Chapter X is to solve this problem.0. The point sought for above may be made dearer by an analogy. Sup -pose that one wishes to travd from A to B by automobile and is interested inmakmg the trip quickly, cheaply, and safdy . Speed, economy, and safety areconflicting ends. Th e greater the speed the less safety and economy. SimDarly


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5 0 QUARTERLY JOURNAL OF ECONOMICSfinancial, and court fees paid for services.* The indirect cos ts, onthe other hand, have usually been the unfortunate consequencesin terms cf lost business, decline in competitive position, loweringof the working morale, and the like, occasioned by the often longinterval between failure and successful reorganization. T he reasonsfor such a lag are many but need not be gone into at this pdnt; itis suflScient to emphasise the importance of curtailing the costs ofreorganization to the appropriate Tninirfiiim.

The five "problems" just listed and briefiy discussed seem tothe writer the most important of those that any established pro-cedure of corporate reorganization will have to meet and solveThe manner in which equity. Section 77B, and the Chandler Bilhave yielded solution to them, and the adequacy of these solutions,therefore provide convenient criteria by which to compare thesedifferent syste m s of reorganization. B ut that task will have t o beundertaken on another occasion.

S. BUCHANAN.Um VE BS ITT OF CALITOBinA AT B E R K E L E T

1. Ill no small measure, of course, these direct costs have been oocasionedby tb e efforts of tbe different conflicting interests to secure relativ dy more forthemselves by a reoiganisation plan wlHcb favon their group at the expense oothers.


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The Economics of Corporate Reorganization